Political Instability: Its Effects on Financial Development, Its Roots in the Severity of Economic Inequality

Abstract

Political instability impedes financial development and is a primary determinant of differences in financial development around the world. Four conventional measures of national political instability — Alesina and Perotti’s (1996) well-known index of instability, a subsequent index derived from Banks’ (2005) work, and two indices of managerial perceptions of nation-by-nation political instability — persistently predict a wide range of national financial development outcomes for recent decades. These results are robust to other factors prominent in the literature in the past decade and hold for a range of key financial outcomes for data over all available years and all available countries over several decades. Political instability’s significance is time consistent back to the 1960’s, the period when the key data becomes available, robust in both country fixed-effects and instrumental variable regressions, and consistent across multiple measures of instability and of financial development. Overall, the results indicate the existence of an important channel running from political instability, principally in nondemocratic settings, to financial backwardness. The robust significance of that channel extends existing work demonstrating the importance of political economy explanations for financial development and financial backwardness. It should help to better understand what policies will work for financial development, because political instability has causes, cures, and effects quite distinct from those of many of the key institutions most studied in the past decade as explaining financial backwardness.